Your plan pay is earned income
An employee's plan pay is their salary. A sole proprietor has no salary, so the tax code uses earned income instead (IRC 401(c)(2)). It is built up in three steps:
- Start with the business's net profit: Schedule C line 31, or Schedule F for a farm.
- Subtract the deduction for half of your self-employment tax.
- Subtract the contributions the business makes to retirement plans for you, including the cash balance contribution itself.
The result is capped at the compensation limit of $360,000 for 2026. Salary deferrals to a 401(k) are added back for most limit tests, so they do not shrink plan pay the way employer contributions do.
Here are the first two steps for $300,000 of net profit in 2026:
| Amount | |
|---|---|
| Net profit | $300,000 |
| Net earnings from self-employment (92.35% of profit) | $277,050 |
| Social Security tax, 12.4% up to $184,500 | $22,878 |
| Medicare tax, 2.9% | $8,034 |
| Self-employment tax | $30,912 |
| Deduction for half of it | $15,456 |
| Earned income before plan contributions | $284,544 |
That last figure is the most this owner can deduct in total across a cash balance plan, 401(k) profit sharing and pre-tax salary deferrals for 2026 (IRC 404(a)(8)(C)), whatever the actuary's maximum says.
Why the calculation is circular
Step three is where it loops. Your pay depends on your contribution, and the contribution depends on your pay. Put $150,000 into the cash balance plan in the example above and earned income for the year falls to $134,544.
That matters in three places:
- The deduction ceiling. Total deductible contributions for you cannot exceed earned income figured before those contributions. The example owner has a hard ceiling of $284,544.
- The benefit limit. A defined benefit plan's limit is partly based on your highest three years of average pay. A large contribution lowers this year's earned income, which can lower that average in later years. The actuary works through the loop until the two agree.
- A 401(k) alongside. When the business also sponsors a 401(k), profit sharing is generally held to 6% of pay in years the cash balance plan is funded, and that pay is itself net of both contributions. See using a cash balance plan with a Solo 401(k).
You do not have to solve any of this yourself. It does explain why a sole proprietor's numbers are only final once the year's profit is known.
What the contribution reduces, and what it does not
The owner's contribution is deducted on your individual return, on Schedule 1 of Form 1040, and not on Schedule C. The IRS is explicit about this, and getting it wrong is a common mistake. Because self-employment tax is worked out from Schedule C, the contribution does not change it.
| No contribution | $150,000 contribution | |
|---|---|---|
| Self-employment tax | $30,912 | $30,912 |
| Adjusted gross income | $284,544 | $134,544 |
| Qualified business income deduction | $6,303 | $23,689 |
| Federal income tax | $60,519 | $15,558 |
In this example income tax falls by $44,961 and self-employment tax does not move. The contribution also lowers the business income used for the 20% qualified business income deduction, which can cut either way. See the QBI deduction and retirement contributions.
The tax is deferred, not forgiven. Money paid out of the plan in retirement is taxed as ordinary income, unless it is rolled into an IRA first, in which case it is taxed when it comes out of the IRA.
Single-member LLCs
A limited liability company with one owner is disregarded for federal income tax by default. It reports on Schedule C like a sole proprietorship, and everything on this page applies to it unchanged.
If the LLC has elected to be taxed as an S corporation, the picture changes completely: plan pay becomes the W-2 salary the company pays you, and profit no longer counts. See S corporation owners.
In a community property state, an LLC owned only by a married couple may also be treated as disregarded. Otherwise an LLC with two or more members files as a partnership. See partners and multi-member LLCs.
Deadlines that suit the self-employed
Because your plan pay is worked out from the whole year's profit, nothing about the cash balance plan has to happen by December 31. The plan can be adopted after the year ends, up to your return's due date with extensions, and funded by the minimum contribution deadline the following September. See cash balance plan deadlines.
The exception is a 401(k). A salary deferral election for the year has to be made by December 31, since a sole proprietor's pay is treated as received on the last day of the year. For a brand-new 401(k), an owner of an unincorporated business who is its only employee can make first-year deferrals up to the unextended return date, April 15, 2027 for 2026.
Other things to know
- A W-2 job as well. Wages from another employer use up part of the Social Security wage base, which lowers your self-employment tax and so raises earned income slightly. Only the side business's income counts toward the plan. See a W-2 job and a side business.
- State tax. Pennsylvania, New Jersey and Massachusetts do not let sole proprietors deduct these contributions on the state return. See states that tax retirement contributions.
- More than one business. Several sole proprietorships owned by the same person are treated as one employer for plan purposes. If one of them has employees, that affects all of them.
- Only earned income counts. Rental or investment income cannot support a contribution, however large.
The cash balance plan calculator runs the earned income calculation from your net profit and shows the result next to the plan's limit.